There is an ever-expanding number of investors have discovered the numerous benefits of purchasing income-generating real estate with Self-Directed IRA money. When appropriately structured, IRA accounts can purchase rental property as an investment, which means you can use your IRA money before retirement age without taking an early distribution and being hit with penalties.

Because the Internal Revenue Code prohibits account holders from extending credit to their own accounts, personal loans can’t be mixed with IRA funds. So typically, one is limited to investments equal to or less than the value of their IRA funds with a self-directed IRA. The challenge, however, is: How do you purchase real estate that costs more than the money you’ve accumulated in your retirement account? For that matter, how can you leverage any investments outside of the stock market that are over the value of your existing IRA funds?

To get supplementary investment dollars, Self-Directed IRA accounts have the ability to make use of borrowed money as long as the credit history, income and/or assets of the account holder are not used to acquire or guarantee repayment of the loan. Based on these criteria, there is one leverage option that would accomplish this:non-recourse loans.

All examples are for educational purposes only, and should NOT be construed as investment advice. Always contact a qualified tax attorney or advisor prior to making any financial decision.

A non-recourse loan is (in this case) a loan made to an IRA (not a person), and it’s based solely on the value of the property (or other asset) acquired with that debt, not the credit of the individual who is the beneficiary of the IRA about to purchase the property.

While a non-recourse loan is a boon to those needing the extra cash, there is a bit of a tradeoff. Understandably, banks are averse to risk and, since there is no personal collateral guaranteeing non-recourse loans, banks must protect themselves. They have no recourse against the IRA or IRA holder with this kind of loan (hence, the name), so the loan typically comes with higher than normal interest rates, and banks typically require that the IRA provide a high down payment on the real estate – anywhere from 30 percent to 50 percent. The high down payment is in case of default: If the IRA-purchased real estate has to be foreclosed on, the bank wants to makes sure it has enough equity to cover costs of foreclosing and sale…while still retaining a profit.

As a rule, banks will also require that a small reserve (up to 20 percent) remain in the Self- Directed IRA account at the time of closing. It’s expected that this money will be used to cover loan payments, maintenance, insurance dues and taxes.

Additionally, the account holder must show that the rental property will provide a positive cash flow based on current vacancy and rental rates. Do be aware that a portion of that rental income, equal to the ratio of debt, is subject to a UDFI (unrelated debt-financed income) tax calculation. UDFI is produced when an IRA or other tax-advantaged entity produces income from an asset that is financed in part or whole through debt.

For example, if the IRA borrows 70 percent of the purchase price, then 70 percent of the income generated by the property is subject to a tax calculation. However, the remaining 30 percent of the income remains tax-deferred, since it belongs to the IRA. Normal tax deductions on the investment (i.e., property taxes, depreciation, etc.) also apply at the same ratio as the ratio of debt, further reducing the potential tax burden.

Using a non-recourse loan in conjunction with your IRA monies can create a powerful wealth-building tool. But it’s a tool that needs to be carefully engaged and properly utilized. It’s extremely important that, in setting up your IRA purchase in conjunction with a non-recourse loan, you work with an experienced and reputable self-directed IRA provider, real estate lender and tax professional.

There are a limited number of banks that will provide non-recourse loans, and it’s worth your while to seek them out. Be prepared for the possibility of some confusion, however, since many banks that have provided non-recourse loans in the past have usually done so for multi-unit or commercial purchases, not single-family homes bought by an IRA as an account investment.

With the right counsel and professional direction, you can fearlessly open the door to many more investment opportunities for your retirement account. And real estate you once thought was out of reach can be yours.

All examples are for educational purposes only, and should NOT be construed as investment advice. Always contact a qualified tax attorney or advisor prior to making any financial decision.